PSP Investments Up 21.5% in FY 2010

The 2010 Annual Report of the Public Sector Pension Investment Board (PSP Investments or PSPIB) was tabled with the Parliament of Canada on July 21st, 2010. On Thursday, PSP Investments posted this press release on its FY2010 results:
The Public Sector Pension Investment Board (PSP Investments) announced today that it recorded an investment return of 21.5% for the fiscal year ended March 31, 2010 (fiscal year 2010), exceeding the Policy Benchmark return of 19.8% by 1.7%. The 2010 performance is one of PSP Investments’ best performances to date and reflects a return to fundamentals from the distressed valuations resulting from the liquidity crisis of the past two years.

In fiscal year 2010, consolidated net assets increased by $12.5 billion, or 37%, to reach $46.3 billion, a new high which exceeds the previous peak of $38.9 billion recorded at the end of March 2008. During fiscal year 2010, PSP investments generated net income from operations of $7.5 billion and received $5.0 billion in net contributions.

“PSP Investments’ 2010 results demonstrate the resilience of our long‐term investment strategy, which began in fiscal year 2004. At that time, we identified the corporation’s strongest competitive advantage to be long‐term liquidity provided from the large annual cash inflows expected to continue beyond 2020,” said Gordon J. Fyfe, President and CEO. “It allows PSP Investments to buy and hold Private Equity, Real Estate and Infrastructure assets for the long term, even during periods of extreme stress as we have just experienced. Unlike other investors, we were not forced to sell high‐quality assets at the most distressed time,” concluded Mr. Fyfe.

The overall performance for fiscal year 2010 was driven primarily by strong results in Public Market equities and the Private Equity portfolio. Investment returns for the public equity portfolios ranged from 20.1% for the US Large Cap Equity portfolio to 47.4% for the Emerging Markets Equity portfolio, while the Private Equity portfolio recorded an investment return of 28.8%. The Real Estate portfolio recorded an investment return of 0.6% while the Infrastructure portfolio achieved a 7.2% investment return for fiscal year 2010.

The asset mix as at March 31, 2010 was as follows: Canadian Equity 29.2%, Real‐Return Assets 20.2%, Foreign Equity 19.8%, Nominal Fixed Income 19.1% and Private Equity 11.7%.

For more information about PSP Investments’ fiscal year 2010 performance, consult PSP Investments’ Annual Report available at

About PSP Investments

The Public Sector Pension Investment Board (“PSP Investments”) is a Canadian crown corporation established to invest the amounts transferred by the federal government equal to the proceeds of the net contributions since April 1, 2000, for the pension plans of the Public Service, the Canadian Forces and the Royal Canadian Mounted Police, and since March 1, 2007, for the Reserve Force Pension Plan.

Its statutory objectives are to manage the funds entrusted to it in the best interests of the contributors and beneficiaries of the Plans and to maximize investment returns without undue risk of loss, having regard to the funding, policies and requirements of the Plans and their ability to meet their financial obligations.
The full 2010 Annual Report is available on-line (click here for PDF file). Obviously, PSP did a 180 degree turn from FY2009 where they lost 23% and severely underperformed their policy portfolio.

Let's begin with PSP's Chairman of the Board, Paul Cantor's message. On page 4, Mr. Cantor states:
As we can see from the latest results, a substantial portion of the unrealized losses from a year ago have been recuperated, which demonstrates the solid long-term value of PSP Investments’ assets. The fiscal 2010 results also reflect initiatives taken to benefit from the remarkable turnaround of markets.

New investment opportunities will arise as global markets continue to normalize. Given our expected annual cash inflows of approximately $4 billion, PSP Investments is in a favourable position to seize those opportunities. But risk is the handmaiden of opportunity, and we will still need to grapple with the inevitable challenges of future markets.

For PSP Investments, keeping a long-term perspective means remaining faithful to the orientation of a highly diversified portfolio that includes a significant portion of private equity and inflation-hedging real estate and infrastructure assets. Such investments increase the probability of meeting or exceeding the targeted 4.3%-above-inflation level of returns, without an unwarranted increase in risk and provide for a better match with the Plans’ liabilities.

We are mindful that PSP Investments’ legislated mandate is to “maximize returns without undue risk of loss”. The events of fiscal year 2009 made evident the need to more clearly define this notion of undue risk with our stakeholders.

The Board has been addressing this question, and will be proposing a comprehensive framework in fiscal year 2011. Beyond that, internally, one of the Board of Directors’ on-going priorities entails working with management to further enhance risk management practices. Our aim is to use what we have learned from the recent crisis to further refine both our quantitative and qualitative parameters for evaluating, monitoring and mitigating risk.
It worries me that after all these years, and after experiencing the 2008 financial crisis, PSP Investments is still trying to figure out the notion of undue risk with their stakeholders. The latter are mostly to blame for this lack of proper oversight.

As I have repeatedly stated, managing pension money isn't about shooting the lights out, doubling down when things go wrong, it's mostly about managing downside risk. And managing downside risk in today's zero interest rate policy world where pension funds, sovereign wealth funds, insurance funds are all chasing indexes and "hot alternative investments" isn't as simple as people think. Importantly, correlations are breaking down a lot more often nowadays, placing a lot of pressure on senior pension officers struggling to find viable ways to minimize downside risk.

How are pension funds responding? I had lunch today with an industry contact who told me how he sees more and more pensions adopting a liability-driven investment (LDI) approach, moving assets away from public equities into fixed income. He added: "they're leveraging up their bond portfolios like crazy. It's like picking pennies in front of a day they'll get caught and lose their hand."

I replied: "True, this business of pension funds leveraging up their bond portfolio makes me nervous. But if senior pension officers believe we are heading for a protracted period of deflation, why risk their portfolio chasing high beta stocks, hedge funds, private equity, commodities or real estate? You're better off keeping it simple, investing a good chunk of assets in high quality government bonds, protecting your downside (but capping your upside)."

Back to the results. On page 7 of the Annual Report, PSP's President & CEO, Gordon Fyfe, had this comment on FY 2010 results:
The past two years saw the worst financial crisis since the Great Depression, demonstrating the risk of leverage and a lack of liquidity. Many investors missed the sharp rebound in asset prices starting in March 2009, having been forced to sell high-quality assets at the most distressed time.

This was not the case for PSP Investments. In fact, during fiscal year 2010 as our assets under management grew, we were able to purchase an additionnal $3.5 billion in public equities (including emerging markets where PSP has a relatively large exposure) at attractive prices.

Overall, our public equity portfolios generated an investment return of 37.9%, contributing to a strong investment performance for fiscal year 2010.

We also benefited from the high quality of our Private Market assets. Being in a position to hold on to illiquid assets that had been written down to distress valuations as a result of the liquidity crisis enabled us to generate significant investment returns, as values returned to fundamentals. The most probing example is the 28.8% return achieved in our Private Equity portfolio in fiscal year 2010.

Finally, we were able to rebalance our portfolio, at or near target asset allocation as our confidence in the strength of the rebound in public equities grew.
Gordon is right, many investors did miss the sharp rebound in asset prices starting in March 2009, and were forced to sell high-quality assets at the most distressed time. It was a matter of liquidity - those pension funds that needed it the most during the crisis were the ones who suffered the most. Other funds like PSPIB and CPPIB, were able to sit back and wait out the crisis without having to sell any of their public or private market holdings (at the market bottom).

Sure, PSP got hit on their illiquid assets in FY 2009, and had to write down their Private Equity portfolio, but as markets rallied sharply since March 2009, those assets were written back up. That's why just like those California pension giants, PSP's Private Equity portfolio had a 29% gain.

How important was that 29% gain in Private Equity? Consider this, on the bottom of page 16 of the 2010 Annual Report:
The excess return of 1.7% (compared to the Policy Benchmark) achieved during fiscal year 2010 was primarily generated by the Private Equity and Infrastructure asset classes, as well as by absolute-return mandates.

Major contributors to excess return in absolute-return mandates included externally managed debt portfolios that benefited from the effect of narrowing credit spreads. PSP Investments’ holdings in collateralized debt obligations and asset-backed term notes (referred to as asset-backed commercial paper in last year’s annual report) also were contributors to the fiscal 2010 excess return. For the fiscal year ended March 31, 2010, investments in collateralized debt obligations increased overall returns by 1.2%, as a result of $393 million in investment income generated in the fiscal year. Our investment in asset-backed term notes generated investment income of $260 million in the fiscal year, increasing the overall rate of return by 0.9%.

Tightening credit spreads and generally favorable market conditions, compared to the previous year, were the primary reasons for the increase in value of these investments. As was mentioned in last year’s annual report, the losses recorded in fiscal year 2009 financial statements related to these investments were primarily the result of stressed market conditions and not related to any significant realized credit losses.
Taking an even closer look at Private Equity's performance (page 19):
Net assets of the Private Equity portfolio totalled $5.4 billion at the end of fiscal year 2010, an increase of $1.2 billion from $4.2 billion at the end of fiscal year 2009.

Private Equity generated $1.2 billion in investment income for a rate of return of 28.8% for fiscal year 2010, compared to the Policy Benchmark return of 13.5%. The robust Private Equity performance for fiscal year 2010 was driven mainly by the direct and co-investment portfolio, which generated $489 million in investment income during the fiscal year, as well as significant performance from a select number of key partners.

On a five-year basis, Private Equity investments generated a negative 0.9% compound annualized return, compared to the Policy Benchmark negative return of 6.7% for the same period.

The Private Equity portfolio has a long-term focus. Investments are held for an average of 5 to 10 years. The Private Equity portfolio is invested globally in collaboration with strategic partners with whom PSP Investments has established relationships. PSP Investments continues to diversify its Private Equity portfolio, with direct and co-investments playing an increasingly important role. As at March 31, 2010, direct and co-investments accounted for 27% of assets of the Private Equity Portfolio, up from 21% at the end of the previous fiscal year. Direct and co-investments amounted to $1.4 billion at the end of fiscal year 2010.

Overall, the Private Equity Portfolio is well diversified both from a geographic and sector perspective. The increase in Canadian and telecom assets is mainly related to the strong performance of Telesat.
We still don't know the details about Telesat's performance, but as I suspected, the $1.5B plus secondary market sale PSP is reportedly engaged in, has more to do with a shift towards co-investments and direct investments which allows them to realize gains on their private equity investments more quickly.

Now, a note on the Private Equity benchmark. PSP does not publicly disclose the benchmarks for private markets citing "competitive reasons", but the biggest problem with PE (and infrastructure) is that it is still in ramp-up mode. I mention this because it's not fair comparing PSP Private Equity or Infrastructure benchmarks to other more mature funds that have ramped up their portfolios.

Infrastructure, led by Bruno Guilmette, is just ramping up, and earned $158 million in investment income for a return of 7.2% in FY 2010, compared to the Policy Benchmark of 3.7%:
A significant portion of the portfolio return was generated by cash distributions (interest and dividends) and realizations from direct or co-investments. Again this year, the performance was largely attributable to direct investments. Since inception (3.75 years), Infrastructure investments have generated a 6.2% compound annualized return, compared to a Policy Benchmark return 3.4% for the same period.
Real Estate, led by Neil Cunningham, has fully ramped up but has struggled in the last couple of years. Still, it is doing comparatively better than large US and Canadian funds:
Real Estate earned $28 million in investment income for a return of 0.6% in fiscal year 2010, compared to a Policy Benchmark of 7.4%. The Real Estate portfolio maintained its value during the year despite an extremely adverse market.

This is largely attributable to a strategy of investing a large portion of the portfolio in the Canadian market, which has shown more stability than other markets during this period, and the adoption of a defensive asset mix over the past three years, with a significant portion of the portfolio being invested in residential, retirement and long-term-care facilities.

On a five-year basis, Real Estate investments have generated a 6.5% compound annualized return, compared to a Policy Benchmark return of 7.3% for the same period.
Let me wind down here by commenting on overall results. While PSP Investments did bounce back solidly from last year's disaster, not missing the rally in stocks since March, the results are not as spectacular as the headline figure implies. In fact, the table below was taken from Brockhouse Cooper's Q1 Universes (click on image to enlarge):

As you see, the median one-year return for Canadian Balanced funds at the end of Q1 2010 (PSP's fiscal year ends March 31st), was 23.1% and the Brockhouse Cooper Balanced Index was up 21.2% for the year ending March 31st, 2010. Hence, while PSP delivered a solid performance, it wasn't "stellar", and PSP was lucky its fiscal year ended before the May-June period where equity markets got whacked hard.

In his message, Mr. Fyfe didn't place too much emphasis on the annual result, focusing more on long-term results:
While we are pleased with our strong performance in fiscal year 2010, one cannot fully judge the effectiveness of a long term investment strategy like PSP Investments’ on the basis of a single year’s results — good or bad.

Perhaps the best measure of success is to look back at PSP Investments’ performance since fiscal year 2004, when we began implementing our diversification and active management strategy. During this seven-year period, we have achieved a net 5.8% annualized real rate of return (i.e. after subtracting expenses and inflation), exceeding the 4.3% real rate of return objective. This investment return was achieved despite experiencing the worst deterioration of financial markets since the 1930s in fiscal year 2009.

With the prospect of positive net cash flows of more than $4 billion per year in the near future, and positive net contributions expected for the next two decades, PSP Investments’ strategy remains sound. Moreover, at a time when some asset classes are still distressed, we are well positioned to capitalize on investment opportunities.
True, but over the last five years, PSP's returns are 4.4% while the Policy Benchmark returned 5.3% (click on first chart above). Despite this long-term underperformance, PSP's senior officers enjoyed another stellar year in terms of compensation. Once again, top compensation went to senior officers in the Private Markets. Derek Murphy, First Vice-President of Private Equity, garnered the largest compensation among senior officers, earning $1,543,265 for FY 2010.

The summary compensation table below was taken from page 46 of the 2010 Annual Report (click on image to enlarge):

The Chairman of the Board defended PSP's compensation practices:
During fiscal year 2010, PSP Investments completed a thorough analysis of its overall compensation practices and procedures and evaluated their compliance with the recommendations of the G20 Working Group which are based on the Financial Stability Forum Principles for Sound Compensation Practices. This self assessment concluded that PSP Investments’ compensation programs and policies are consistent with the G20 Recommendations, and that compensation programs are effectively designed to reduce the potential for rewarding excessive risk taking.

In the interest of sound governance and impartiality, the Board and the Human Resources Compensation Committee also mandated Deloitte & Touche LLP to conduct an independent review of PSP Investments’ assessment. Deloitte & Touche LLP confirmed PSP Investments’ level of compliance with the G20 Recommendations.
But union leaders representing federal civil servants aren't happy with compensation and other governance issues at PSP. In fact, the Public Service Alliance of Canada (PSAC) shared these concerns with me:
1- the return of the PSPIB must be put in perspective: There is a 21.5% return for fiscal year ending March 31st 2010, but over the same period time the S&P/TSX Composite Index increased by 34.6%.
2- PSPIB has underperformed against the established policy benchmark in 5 of the 10 years since commencement of operations.
3- A total of $4.2 million in incentive bonuses (annual and deferred) paid to the top 6 executive officers of PSPIB in fiscal 2010 in comparison with a total of $3.8 million in incentive bonuses (annual and deferred) paid to the top 6 executive officers of PSPIB in fiscal 2009 - an approximate increase of 10%
4-The Unions are still prevented from serving on the PSPIB.
5- The Federal government is currently contemplating even higher contribution rates on behalf of employees.
It's easier to defend bonuses when the PSP Fund performs well as it did in FY 2010. But as I stated before, nobody should have received any bonuses last year after that disastrous performance. And given that PSPIB is underforming its Policy Benchmark over the last five years, I can see why some are concerned about the level of compensation doled out to senior officers during that period.

As far as board representation, I do feel that unions of all three key stakeholders should have some representation on the Board. This may not please other board members who are nominated, but unions have every right to have representation on that Board (right now, the Act governing PSPIB prevents union members from sitting on the Board).

Let me end this long comment by noting something Mr. Fyfe wrote in his message:
An on-going priority to successfully implement our 2012 strategic plan has been the recruitment, development and retention of the top talent required to effectively manage a large and complex investment fund.

As we round out the leadership team, PSP Investments’ pool of human resources has acquired the critical mass and collective expertise that enable us to shift our primary focus from recruitment to professional development and succession planning. Accordingly, we are conducting talent reviews with middle management, developing formal succession plans and implementing a structured approach to the development of new managers, while continuing to refine our hiring practices.
I am happy to hear that PSP is placing priority on recruiting, developing and retaining top talent. My measure of success at any investment shop - be it a pension fund, a mutual fund, or a hedge fund - is the turnover rate at these places.

Unfortunately, the turnover rate at some long-term pension funds has been abysmally high in recent years. This is totally unacceptable and a clear sign of managerial weakness. I mention this point not to target anyone in particular, but because I believe in retaining good people and developing them as they progress in their career.

Finally, let me personally congratulate Gordon and his senior team for delivering solid results in FY 2010. I haven't always been easy on PSP but I am able to give credit where credit is due.

And while some think I want PSP to fail, nothing can be further from the truth. Gordon came through for me at a very difficult time in my life, offering me an incredible opportunity to work in a field I truly love. My experience at PSP was for the most part a positive one where I learned a lot about various asset classes in both private and public markets. Montreal is better off for having PSP's business office here and I wish them many more years of success.

***Feedback on PSP's FY 2010 Results***

A senior pension officer shared these thoughts with me:

Telsat looks like the outlier sized direct PE investment that is going well. Satellite is an area that is getting more valuable, regulatory changes and spectrum requirements mean that while they bought this asset for a very high price it should provide a decent medium term return potential, although their old satellites are of waning value by nature. Deals are apparently imminent on their sale of pe funds, probably some structured deal of sorts. So it appears they will free up capital and be a force to be reckoned with going forward. But it all remains a large experiment with people who remain unproven investors.

Like CPPIB, they have not provided any net value since their creation versus and all Canadian bond portfolio, nor has PE made any money since inception, even after currency gains. Yes, it is still (relatively) early days, etc. but the bottom line is these places take way too much risk before they are operationally seasoned, and people have had a chance to work together. And, it looks like the strategy is, “we survived, now we will take advantage of others who failed and all the opportunities out there”. This is naïve. Few others actually failed, and the global glut of capital means returns for risk remains highly problematic. They have few if any advantages as investors other than their non-taxable status which they generally pay away to the sellers of assets due to the competitive market out there. I think that in the next ten years, once again these places will add no value (make no money).

And he added:
I don’t mean to be too negative, it’s just that being accountable means at a Board they need to revisit the entirely of what they are trying to achieve, and whether it is possible. They obviously think staying the course is appropriate, but if they don’t say stop, or slow down, who will? Looks like a self perpetuating organization, which is why there shouldn’t be many of these created, and why they should be capped in the amount of capital allowed to any one organization. The govt. needs more diversity of approaches, even if that costs economies of scale (which may not exist beyond a certain point anyway).

Note that the Dutch pension giant ABP is essentially setting the stage to exit PE as a line of business. They are recognizing the reality of the glut of capital, and why be illiquid if you don’t get paid for illiquidity?